A State-Space Version of Fama and French’s Three-Factor Model: Evidence from the Tunisian Stock Exchange

Nejla Bergaoui,Abdelwahed Trabelsi

doi:10.5539/ijbm.v11n11p214

Abstract

We develop a state-space version of the three-factor model of Fama and French (1993) for exploring the macroeconomic determinants of risk underlying size (SMB) and value (HML) factors. To the best of our knowledge, this is the first study that examines how loadings on HML and SMB factors are affected by unanticipated changes in macroeconomic factors and whether they exhibit an asymmetric behavior over the business cycle. We test the hypothesis that the betas associated with HML and SMB factors of firms with different size or a different BE/ME ratio react differently to changes in macroeconomic conditions. In addition to the hypothesis that some type of stocks (value and small ones) become more responsive to such a change during period of economic contraction than during an expansion. Our focus is the Tunisian stock Exchange. The evidence we found supports the time variation of portfolios returns’ sensitivities to market, HML and SMB factors with unanticipated changes in monetary and economic conditions. Hence, the assumption of constant coefficients in the traditional three-factor model seems to be unreasonable. Betas associated with HML and SMB factors showed countercyclical behavior through the phases of the business cycle. In a recession, value (small) firm’s risk associated with the HML (SMB) factor is more strongly affected by worsening credit market conditions than during an economic expansion. Further results show that value (small) firm’s risk associated with the HML (SMB) factor is more strongly affected by tighter credit market conditions than growth (large) firm’s risk. Thus, our results most closely support a risk-based explanation for SMB and HML.

Highlights

A large body of empirical research gives evidence that the market beta is imperfect and insufficient to explain the higher returns of certain assets relative to others
In an earlier paper (Bergaoui, 2015) we evaluated the relationship of some market- and accounting-based measures of financial distress risk and profitability with BE/ME and size (ME) for stocks listed in the Tunisian stock Exchange (TSE), over the period July 1998 to December 2010
It is a flexible framework that allows the betas of the model to vary with the state of the economy and with the underlying macroeconomic fundamentals that measure changes in credit market conditions

Summary

Introduction

A large body of empirical research gives evidence that the market beta is imperfect and insufficient to explain the higher returns of certain assets relative to others. The study of Perez-Quiros and Timmermann (2000) aims to test the hypothesis that small-cap stocks are more adversely affected by tighter credit market conditions (lower liquidity and higher short-term interest rates) than large stocks, especially during periods of economic downturns They model excess returns of 10 size-sorted decile portfolios as a function of an intercept term and lagged values of the one-month T-bill rate, a default premium, changes in money stock and dividend yield. There has been little direct evidence to date (if any) on the time variation of loadings on the HML and SMB factors of Fama and French (1993) These different studies ask whether there exists a differential response in expected returns to negative monetary policy shocks between small (value) and large (growth) firms. Our results confirm the presence of significant and strong BE/ME and size effects in the Tunisian stocks returns

Portfolios Returns

Macroeconomic Factors

Estimation of Conditional Betas and Specification Tests

Conclusions